A 2-Speed Europe Puts The EUR Where?

by: Dean Popplewell

Presently, all news and data is going against the EUR. European growth remains very mixed with the word "contraction" being uttered more often than policy makers would like. Data released this morning indicates that the eurozone's economy expanded at a surprisingly low pace last quarter despite a strong recovery in Germany. Other key euro members either stalled or contracted.

Gross domestic product grew at +0.2% in Q1, well short of the +0.4% that was forecasted. In annualized terms, that's a meager +0.8% growth rate. The morning's results indicate that the euro region's growth remains both tepid and vulnerable with many of the economies on a widely opposing growth path. For instance, France's economy is stalling; Italy's contracting slightly, while Portugal fell back into contraction after three positive quarters (-0.7%), similar to the Netherlands who posted a sharp drop in output (-1.4%). There are no real surprises with the eurozone's largest and most dominant economy, Germany. Its GDP swelled +0.8% from the previous quarter or +3% y/y. Both consumer and government spending are the driving force behind its growth. Unlike France, its economy has stalled on the back of consumer spending and investment declining.

Combining weaker euro growth with today's low euro inflation reported this morning (+0.7% y/y in April) only heightens market expectation that the ECB will finally pull the "easing" trigger and reduce interest rates. It would not surprise many to see the euro policy makers sanction other stimulus measures on June 5th to stimulate new lending to the private sector. Today's data as a whole should provide the ECB some hope that the region's current bout of inflation, obviously complicated by a high EUR of late, has not derailed the bloc's economy just yet. Nevertheless, the region's growth remains well below the desired +2% print that many expect is required to put a meaningful dent in unemployment. The region's "unused" capacity or "slack" is keeping the eurozone further away from the exit unlike the US where growth happens to be more buoyant. The ECB's continued problem is that growth remains heavily dependent on Germany; however, its economy is forecasted to stutter in Q2. The bloc cannot even rely on the second largest- France - with no growth, it's anticipated to be a drag on team members this year.

The EUR continues to pullback aggressively with a new move low this morning; taking things back to the congested €1.3650 region. It was last week's ECB meeting that kicked off the latest down-leg on the EUR outright (€1.3995). The initial impetus came from Draghi - "we're ready to act" – follow-through has come from confirmation that Germany's Bundesbank will support any ECB action in June. Further follow-through and a firm moves below the €1.3700 psychological level has come from speculation that Draghi and company could cut the deposit rate by more than the expected -10-15bps. But with the single currency trading within striking distance of this year's lows, where to from here? There does not seem to be much in the way of ECB inspired news to help push the unit move lower. Any further weakness is now most likely dependent upon option or spot related positioning – currently they seem to be pulling in opposite directions.

For many, option vols have been a very good indicator for sustainability in respect to EUR moves. Despite the EUR's break, lower vols seem to have stayed offered. One-month EUR/USD vol hit 6.1% yesterday and its 5.8% today despite the single currency's losses. Realized vols remaining well below implied today's single-currency losses are exciting only spot traders and speculators – the option trader seems non-fussed. Perhaps the risk reward, especially at such extravagant price levels, may convince more to consider wagering against the current ECB/EUR hype?

Currently, the long-term spec community remains positioned "long" EURs while the short-term traders (intraday) have remained most likely short. Looking at the options market, there is little strike gravitational activity to the downside; however on the topside there is a €1.8b expiry at €1.3750 coming off on Friday. Assuming the status quo remains, Friday could see a bit of a correction. However, the overall trend remains for further EUR losses. Many will want to see how US CPI performs later this morning – there is a risk that it could come in higher than expected (+0.3%). If it does it will make playing a short term EUR correction more difficult. A convincing break of €1.3643 below will result in the techies' 2012-14 uptrend line at €1.3382 being tested. With the trend remaining your friend, short term rallies, should be capped below €1.3770.

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